Does debt drag you from riches to rags or is it just the opposite? Tough to tell. A lot depends on your circumstance. Some radio shows and financial websites reflect only on the bad side of debt. No wonder too many consumers assume that debt affects their net worth negatively. But this isn't always true.
Before we dig deep into this subject, let’s talk about net worth first.
Net worth is your accumulated wealth. You can calculate it by subtracting all your liabilities from your total assets.
When debt does not make any difference to your net worth
Suppose you don’t have assets or liabilities. You decide to take out $5000 from the bank. After you borrow the amount from the bank, you keep it in your savings account. Now, what is your net worth? It’s zero. You may feel wealthy since you have $5000 in your bank account. But don’t forget that you have to pay off this amount later. You have $5000 in liabilities. So you may feel poor even after having $5000 in your bank account. But considering the overall scenario, your net worth is zero.
How can debt help to increase your net worth
You have to use the loan wisely. Suppose you take out a loan of $10,000. You use the money to complete your higher studies and get a good job with a fat paycheck. Once you get a job, your financial situation stabilizes. You can use the money to pay off debts and lead a comfortable life. You can save money and buy a nice apartment later.
There is yet another way to increase your net worth. You can invest the money in stock market or foreign exchange market or a commodity market to get higher returns. If you earn more than the interest-rate you’re paying on your existing loan, then your net worth is positive.
If you borrow a high-interest loan and simply keep it in your bank account, then your net worth won’t increase. It will be negative.
When does debt decrease your net worth?
Like I said, it all depends on how you use the loan. If you use $5000 to buy expensive clothes, then its effect on your net worth is negative. If you spend the money to have lavish dinners at expensive restaurants or costly vacations, then also your net worth will be negative.
It’s wrong to blame debt. Just imagine the plight of undergraduates if there were no student loans. The cost of higher studies is known to all. How would have these poor fellows completed their studies? Think about business loans. These loans have produced so many entrepreneurs in the country. And how can we forget home loans? These loans help us to live in a beautiful home.
Your net worth will be positive if you use $5000 to buy a reliable used car and use it for getting a job that pays more than $5000 every year.
You need to analyze how new debt can affect your net worth prior to taking out a loan. The cost of the loan and the way you use it make a positive or a negative impact on your net worth. So you need to be careful.
Debts are not evil. If you can use a loan prudently, your net worth will increase overtime. Here are a few tips that can help you use debt to increase your net worth gradually. Don’t borrow money to buy iPads, TV, smartphones, clothes, etc. These are durable consumer products. These products won’t increase your net worth. Don’t use the money for sponsoring vacations and dinners. If you use the loan to buy any product, make sure you pay it off before you stop enjoying the products. Invest wisely so as to grow your money.